Options

Real Options

• Managers have options to adapt and revise decisions.

• Flexibility is valuable.

• Value of flexibility should be accounted for.

Real Options and Financial Options

• Option Definition – the right (but not the obligation) , to buy/sell an underlying asset at a price (the exercise price) that maybe different than the market price.

Real Options Vs. Financial OptionsNot traded on an exchange.

The underlying asset is something other than a security

Options on stocks, stock indices, foreign exchange, gold, silver, wheat,

etc.

Real Options

• Identification– Are there real options imbedded in this project?– What type of options?

• Valuation– How do we value options?– How do we value different types of options?– Can’t we just use NPV?

Identifying Real Options

• Value• Almost always exist• Art:– Identify options that are “significant”– Ignore options that are not

• Identifying real options takes practice, and some times “vision”.

Identifying Real Options

• 4 types1. Growth 2. Abandon 3. Investment Timing4. Switch

• Key elements– Information will arrive in the future– Decisions can be made after the information

Options vs. DCF

• DCF method:– “expected scenario” of cash flows– Discount the expected cash flows

• DCF is fine – as long as – – Expected cash flows are estimated properly– Discount rates are estimated properly

• Complex options make it difficult to estimate

Start with “Static” DCF Analysis

• Begin by valuing project with no options– Pretend the investment decision must be taken

immediately. • This benchmark constitutes a lower bound for

the project’s value. – NPV < 0 – Does not mean:

•

– NPV > 0 – Does not mean:• •

Growth Option (1)

• A company is considering a project that has an initial cost of $500,000.

• The project is expected to produce cash flows of $100,000 at the end of each of the next 5 years, and has a WACC of 12%.

• Should they take the project?

Growth Option (1)

• There is a 10% chance the project will lead to subsequent opportunities that have an NPV of $3,000,000 at t = 5, and a 90% chance of an NPV of -$1,000,000 at t = 5.

NPV with the Growth Option

• At WACC = 12%,– –

• Project NPV–

100,000 100,000 100,000 100,000 100,000

-$500,000

10% prob.

90% prob.1 2 3 4 5 Years0

100,000 100,000 100,000 100,000 100,000-$1,000,000

$3,000,000

Growth Option (2)

• Suppose GRE Inc is considering a $3M investment. There is a 50% probability of success in which case they will earn 1.5M for 3 years. And, there is a 50% probability of poor results in which case they will earn only $1.1 for 3 years. It is considered to be a relatively risky investment with a WACC of 12%. What is the NPV of this project?

Growth Option (2)

• However, if the plan is successful at the end of the first year, then GRE Inc could invest another $1M at the end of the first year. This additional investment is expected to yield an additional cash flow of $5 the following year. What is the value of the growth option?

Part I - Project without the Growth OptionOutcome Prob. 0 1 2 3 NPVGood 50% -3 1.5 1.5 1.5 $0.603Bad 50% -3 1.1 1.1 1.1 ($0.358)

Expected NPV $0.122

Part II - Project with the Growth OptionInitial Investmet -3 1.5 1.5 1.5Growth Option -1 5Good 50% -3 1.5 0.5 6.5 $3.364Bad 50% -3 1.1 1.1 1.1 ($0.358)

Expected NPV $1.503

• The value of the option:$

Abandonment Option

• A project has an initial, up-front cost of $200,000. The project is expected to produce cash flows of $80,000 for the next three years.

• At a 10% WACC, should we take the project?– The NPV is -1051.84. – No, don’t take the project.

Abandonment Option

• The project’s cash flows depend critically upon customer acceptance of the product.

• There is a 60% probability that the product will be wildly successful and produce CFs of $150,000, and a 40% chance it will produce annual CFs of $25,000.

Abandonment Decision Tree

• If the customer uses the productNPV = $173,027.80.

• If the customer does not use the product, NPV is -$262,171.30.

• Overall,

-$200,00060% prob.

40% prob.1 2 3 Years0

150,000 150,000 150,000

-25,000 -25,000 -25,000

Issues with Abandonment Options

• The company does not have the option to delay the project.

• The company may abandon the project after a year, if the customer has not adopted the product.

• If the project is abandoned, there will be no operating costs incurred nor cash inflows received after the first year.

NPV with Abandonment Option

• If the customer uses the product, NPV is still $173,027.80.

• If the customer does not use the product and it can be abandoned after Year 1, NPV is $222,727.27.

• Overall,

-$200,00060% prob.

40% prob.1 2 3 Years0

150,000 150,000 150,000

-25,000

Should an abandonment option affect a project’s WACC?

Investment Timing Option

• A company is considering a project that has an up-front cost of $100,000. The project is expected to produce cash flows of $33,500 at the end of each of the next four years. The project has a WACC = 10%.

• Should they take the project now? • However, if the company waits a year they

will find out more information.

Investment Timing Option

• If they wait a year:– There is a 50% chance the market will be strong and the

expected cash flows will be $43,500 a year for four years.

– There is a 50% chance the market will be weak and the expected cash flows will be $23,500 a year for four years.

– The project’s initial cost will remain $100,000, but it will be incurred at t = 1 only if it makes sense at that time to proceed with the project.

• Should the company go ahead with the project today or wait for more information?

Investment Timing Decision Tree

• At WACC = 10%, the NPV at t = 1 is:$37,889, if CF’s are $43,500 per year, or -$25,508, if CF’s are $23,500 per year, in which case the firm would not proceed with the project.

50% prob.

50% prob.0 1 2 3 4 5 Years

-$100,000 43,500 43,500 43,500 43,500

-$100,000 23,500 23,500 23,500 23,500

Should we wait or proceed?

Factors to Consider In Decision of When to Invest

• Delaying the project means that cash flows come later rather than sooner.

• It might make sense to proceed today if there are important advantages to being the first competitor to enter a market.

• Waiting may allow you to take advantage of changing conditions.